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Monday, July 06, 2015

Concerns about the valuation of the broad equity market

The macroeconomic context

A group of articles here has explored present business cycle conditions. We started at the currency defence of 2013, to the question of present business cycle conditions, and went on to the balance sheet problems of banks and non-financial firms. These three components add up to a useful picture of the macroeconomy.

In this setting, what do we see about earnings growth and the valuation of the broad equity market? This fourth component of thinking about the macroeconomy is pursued ahead.

Equity market valuation

Equity market valuation is all about two things: projected earnings growth and the discount rate required by the market. In the past, Indian equities have obtained high valuations on the strength of the high growth rate of earnings. For a long time, there has been a nice set of thumb rules about India: nominal GDP growth of 10%, top line (i.e. revenue) growth for firms of 15% and bottom line (i.e. PAT) growth for firms of 20%. Once you get comfortable around the notion of sustained 20% earnings growth, a very big valuation can be sustained.

How have things been going of late?

Figure 1: Growth of nominal profit after tax (PAT) of non-financial firms

We start with an examination of the profit after tax of non-financial firms. The method for constructing an index of nominal net profit is the same as that used for nominal net sales that's described here. In the past, this has had very high growth rates. The index rose by ten-fold in less than a decade. However, there has not been much expansion of earnings from 2006 till today. In the latest recession, which began in Q1 2012, earnings have been on a slighly negative trend.

In the lower pane, the blue line is the long run median value. After Q1 2012, i.e. in the current recession, there have been only four quarters with a bigger value for growth when compared with the long run median.

Figure 2: Growth of operating profit (PBDIT) of non-financial firms

PAT is a very small number, and is sensitive to changes in depreciation, interest and tax. To understand the dynamism of the underlying business, it's useful to look at the operating profit (PBDIT). As the graph above shows, here the picture is better in that there has been some growth after 2006. However, in the latest period, the trend growth rate is 5.65% per year, which is anemic.

Here also, the blue line is the long run median growth. In the recession which began in Q1 2012, there have been only three quarters with growth that was above this long-run median.

Figure 3: Trailing P/E of the CMIE Cospi index

This takes us to the valuation of the equity market. We use the CMIE Cospi index as a measure of the broad market. The trailing P/E is computed as today's market capitalisation divided by the sum of four latest quarterly earnings. This went up from the region of 16 to 26, an increase of 62.5%. However, the prospects of earnings growth appear to be worse than the long run median value.

This can be rationalised in one of two ways. Either the market believes that the engine of earnings growth is about to get going again, or the market now has a reduced required rate of return. The dates of the 62.5% rally line up with expectations of a majority for the BJP in the elections of 2014, which emphasises an explanation based on optimism.

It is interesting to look at the first of the three recessions in this date range: from Q4 2000 to Q1 2002. Figure 1 shows that earnings immediately took off when the recession ended. But the stock market was mistrustful for a while. All the way till 2005, the trailing P/E had not gone up; the market had not understood that it was in the biggest ever earnings expansion of India's history. P/E ratios are good cross-sectional forecasters of future earnings growth but perhaps the market is not so good at understanding the business cycle. As an example, this thinking in 2007 was out of line with the optimism of the market.


The currency defence of 2013 was an important negative event for the economy; it damaged confidence and hurt the economy with a sudden 440 basis point hike in the interest rate. A business cycle downturn began in Q2 2012 which has not yet ended. This has gone along with slow earnings growth. In this period, there seem to be significant balance sheet difficulties with some banks and some non-financial firms. This debt overhang hampers the recovery of the economy and adversely affects the prospects of earnings growth. It is hard to reconcile this picture with the valuation of the equity market.

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